Progress Made on Eurozone Policy Response, Risks Remain

Posted: 21 September 2012 | Source: Fitch Ratings

Eurozone policy makers have recently outlined or clarified their desired approach to facilitating greater Economic and Monetary Union and avoid the high economic and political costs of a eurozone break up. This supports Fitch's view that the eurozone will survive. However, political and execution risk remain high. Despite the progress made this month, solving the crisis is far from certain and any resolution will not be quick.

In May we identified six broad areas that needed to be addressed before market speculation about the eurozone's viability is likely to abate: European Central Bank funding; banking supervision; a credible financial firewall; structural economic reform; fiscal integration; and political and institutional reform. Progress has been made on the first four, and European Commission president Jose Manuel Barroso has made early-stage remarks about the last two.

The ECB announced on 6 September a new, unlimited sovereign bond buying programme, Outright Monetary Transactions, in which it would not be a preferred creditor. By removing the convertibility risk premium and addressing investor concerns about subordination, this initiative should lower the risk of self-fulfilling liquidity crises, although ECB intervention needs to support market access rather than be a substitute for it.

The European Commission's proposal on 12 September for a "single supervisory mechanism" for eurozone banks could help break the link between weak banking sectors and sovereign creditworthiness. The proposal is a prerequisite for European Stability Mechanism funds being used to recapitalise banks directly. However, the timetable for initial implementation in early 2013 is tight, and the proposal is likely to be far more ambitious than the agreement eventually reached.

The German Constitutional Court's approval of the creation of the ESM, also on 12 September, should allow German ratification, meaning the minimum number of eurozone members have ratified the mechanism. The Court said any increase in Germany's ESM liabilities above the amount already agreed (EUR190bn) would have to be agreed by parliament.

The ESM's EUR500bn lending ceiling, part of which is already earmarked for Spanish banks, does not cover the medium-term gross funding requirements of Italy and Spain. But as we have previously said, it gives the ESM useful firepower to act as an "anchor investor" in new issues, and alongside the ECB's OMT secondary market purchases could reduce the risk of self-fulfilling liquidity crises. As with OMTs, ESM bond buying needs to be a complement, not alternative, to market funding.

Structural reform has remained a priority in peripheral countries, improving growth potential. OMTs are conditional on a sovereign entering an ESM/European Financial Stability Facility programme that includes macroeconomic adjustments, which may increase the number and importance of reform programmes. There are political risks to further reform, though - in Italy, for example, the prospect of additional reform has arisen ahead of next year's general election.

Reform fatigue is also a risk. Greece has been lobbying for an extension of the timeframe for execution of its austerity and reform programme. An agreement on any change to the Greek programme before the next EU summit in October would reduce the risk of a Greek exit or second default.

A move away from national sovereignty in fiscal policy had already begun when we published our scenario analysis in May, for example via the fiscal compact. Further moves in this direction look likely. In his State of the Union address, European Commission president Jose Manuel Barroso said the Commission will publish a blueprint for deepening economic and monetary union this autumn, and that "over time, steps for genuine mutualisation of debt redemption and debt issuance can take their place."

On longer-term political reform, Barroso said the Commission would "put forward explicit ideas for Treaty change" to create a "federation of national states." However, it is highly uncertain how much political momentum there is for full-blown EU treaty revision, so any Commission proposals may look more like a wish-list at this stage.

The speed and extent of progress on all these policy measures, alongside the success of adjustment programmes and prospects of a return to economic growth, will continue to inform our judgement on the likely resolution of the eurozone crisis.